Study Shows A Link Between ETFs and Correlation

By Brendan Conway

Do exchange-traded funds cause correlation in the markets? No! Shouts the industry. It’s the macroeconomic environment, not our cheap, innovative, and easy-to-trade products.

Among the arguments in their defense, one is pretty airtight: Currencies and other globally traded assets besides stocks have swung closely with other asset classes, too. ETFs are minnows in those markets. They can’t be causing currencies to swing together or the euro to track stock-market moves. Thus, the suggestion is that market correlation has to be bigger than any one investing vehicle or style.

But ETFs could still be contributors to correlation even under those circumstances. This subject has been crying out for academic study, especially studies that aren’t commissioned or otherwise handled by ETF sponsors.

A summary of the findings, which you can read in full by signing up for an SSRN account:

Our paper investigates whether ETFs contribute to equity correlations. First, we perform an ETF-level analysis and find that the more an ETF owns of the market capitalization of its underlying portfolio, the more the stocks in that portfolio tend to move together in the subsequent month. This holds controlling for fund and time fixed eects and a host of control variables. We find that an ETF’s turnover is also a strong determinant of the comovement of the stocks making up its portfolio. The standard deviation of the ETF’s shares outstanding, meant to capture creation and redemption activity, is less strongly related to comovement.

Next, we investigate how ETF ownership of a stock in aggregate relates to its comovement with the market portfolio. We find that the more of a stocks’ market capitalization is owned by ETFs, the more it comoves with the market in the subsequent month. As in the fund-level analysis, we also find that the weighted average turnover of the ETFs that own the stock is related to how much the stock comoves with the market. We find weaker evidence that weighted average creation and redemption activity of the ETFs that hold the stock is related to the stock’s comovement with the market. The effect of ETF holdings is almost three times as large as the effect of mutual fund holdings of a stock and around 10 times as large as the effect of institutional holdings.

It’s hard to think that the immense popularity of indexing, and the swift rise of easy-to-use index trading vehicles, could have happened with no effect whatsoever on how stocks trade.

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